Gold lovers like to point to the Dow-priced-in-gold graph as some sort of argument ender, showing the superiority of old yeller to other financial assets. I don’t really understand that. In fact, like the proficient Paul Kedrosky, I’m never quite sure what to make of these excercises of pricing one asset in terms of another. I love how Paul wrote about it almost exactly a year ago when the gold-versus-Dow-graph was floating around:

I’m always uneasy about these “Let’s price Thing X in Commodity Y” exercises (hey, let’s price yo-yos in meerkats!) – if thing X was supposed to be priced in commodity Y, it would be priced in commodity Y – but this one is at least semi-useful.

And last December, our august cubicle mate E.S. Browning also took a stab at explaining the passion among some for pricing the Dow in gold:

Lately, some investors have gotten interested in measuring the Dow in gold rather than dollars. Gold has rebounded since 1999, and the fascination with the yellow metal has made investors start thinking of it again as a currency.

Ned Davis, the founder of Ned Davis Research, referred to gold as “real money” in a recent report and published charts of bonds, home prices and stocks measured in gold rather than dollars. Even with gold’s swoon in recent days, the Dow looks a lot weaker over the past decade measured in gold than in dollars.

Of course, it is possible to find a hot investment that dwarfs the Dow’s gains over any period, which makes many analysts question the value of adjusting the Dow for gold’s gains. Such skepticism doesn’t stop gold’s supporters from pointing out how much weaker the Dow looks when measured in “hard” money.

As far as I can tell, the only thing this chart tells us is that gold and stocks move in very long term cycles. When people want to buy stocks, like in the 1920s, 1960s and the 1990s, the Dow tends to get too expensive compared to gold. Then gold swings back. Now it looks like there still might be some upside left in the yellow metal before the chart hits the lows that we saw when gold peaked in the early 1930s and 1980s. But as an investor who worries about risk as well as return, it looks pretty clear that we’re far closer to the end of this move than the beginning.

Comments (5 of 18)

1.) Looking at the relationship between two things, in this case, the Dow and Gold, is the only way to get a true measures of value. The Fed's ability to manipulate inflation has made "nominal" prices on things rise yet the "value" of those same things has actually decreased. The Dow/Gold ratio is the perfect example of this.

2.) The Dow/Gold ratio is currently at 8.5. It peaked at over 40 around the year 2000. While this cycle started nearly 10 years ago, it still has several mroe years to run. There are many who are projecting the Dow/Gold ratio to go to 1. Dismissing this cycle as being "nearly done" would be a grave mistake. If the Dow/Gold ratio does go to 1, this could mean $12,000 an once gold, an 8.5 fold increase from where it is today.

3.) Because the Dow/Gold ratio had never been so out of whack as it was in 2000, there is a really good chance we are going to see a once in a lifetime reversal/over-correction of this relationship. A once in a life time event.

4.) It is these relationships that allow you to determine when to enter and exit markets like real estate, commodities, and the stock market.

I do not know if I am a gold lover or a fiat currency hater. What I do know is that a ratio graph with a linear scale is only one way of representing the information. I prefer to look at a chart with a logarithmic scale; after all, buying a Dow for 34 or 35 ounces of gold is something quit different than buying at 3 or 4 ounces.

Yes, I do see gold as money. My stockbroker probably thinks the same as I can use my gold deposits as margin (which I hardly use, by the way....).
And yes, I will switch to stocks when I think this ratio bottoms out. Perhaps in a couple of years.

5:04 pm November 12, 2010

Jeff wrote :

Your analysis completely ignores the dividend paid from the stocks, the storage cost for gold, and changes in the tax rate on said dividends or capital gains. Thus the actual return on investment for the stock market is ignored.
On a separate note,
Unskilled labor is the only commodity in the economy that is legislatively pegged to the dollar (through the minimum wage). You might find it more telling to ratio dow to minimum wage, using numbers for the dow that are adjusted for dividends. I hypothesize that the real inflation of the 2000's was caused by moving the minimum wage from 4.25 to 7.25/hr, and all of the monetary and fiscal policy handwaving can only change HOW the real inflation is realized, and HOW LONG it takes for the inflation to move through the various sectors of the economy.

3:00 pm November 12, 2010

Dave wrote :

It would be interesting to look at a chart of copper vs. gold, steel vs. gold, wheat vs. gold, cotton vs. gold, or milk vs. gold. In other words, if one could see the same fluctuation as is evident above, than the next question would be, what value is really volatile? The "X" commodity or the "Y" commodity? The value of gold as it relates to other items and material varies widely. Why would I sell two "good suits" today to buy two ounces, and two years from now, if the price falls, only be able to buy one good suit for those same two ounces? That's why, instead of just a single asset, you'd want to measure against a "basket" - so the idiosyncratic volatility of the various components cancels each other out.

11:10 am November 12, 2010

Andrew wrote :

I dont understand .. isn't there a lot more stock ( size of companies has physically grown), and none of the gold has evaporated. So bottom line is how gold is added versus how much global consolidation (or stock market reach there is). There is no value in either the article or the chart - but I enjoyed reading -- thanks.

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